Guest Interview:

Merit Advisors, Inc.

121 NE 50th Street
Oklahoma City,OK 73105

Interview Quarter: 2Q2012

Donald L. Dillingham, Portfolio Manager

& Matthew Spangler, Vice-President

Don, why have bonds done so much better than stocks over the past 10 years?

Your question is best asked to one of the talking heads appearing on your favorite market show. In my opinion there are a few simple facts that have contributed to the superior performance in bonds relative to equities:

From an investor’s prospective, bonds are easy. There is an agreement between borrower and investor that outlines the investment returns – payment dates and amounts and when the principal will be repaid. In today’s investment environment, I think people want the simplicity and income offered by bonds.

What events in your background led you to bond management?

Luck. It was 1984 and I had just passed the Series 7 exam as a new retail stockbroker with Stifel, Nicolaus. One of the older brokers told me “Don, if you ever get the chance, you need to go to work on the bond trading desk”. A month or so later, I got the opportunity and spend the next 10 years as a municipal bond trader/underwriter. One day in August 1986 there was talk of ending the tax exemption for municipal bonds and the prices dropped – but not all bonds declined in value by the same amount. Two lessons from my undergraduate days (I was working on my masters at the time) duration and convexity were permanently etched in my mind. The “bond math” – how market events cause substantially different affects on prices for two seemingly similar bonds was intellectually stimulating to me. From that point forward I was fascinated with fixed income price performance and the trends that develop in the market place.

Does Merit Advisors have a guiding investment philosophy?

Yes, we manage money with a trend following system for trading high yield fixed income securities. Our first rule, similar to the Hippocratic Oath,” never do harm to anybody” – we don’t like losing our clients’ money as indicated by our low drawdowns of investor capital. As such our clients tend to be conservative investors who are seeking higher returns than can be earned in U. S. Treasury bonds or bank Certificate of Deposits.

We achieve different results because we manage money differently. We operate a technical system, versus a fundamental system used by most advisors. At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements.

Technical systems (like Merits) operate on the premise that there is no reason to analyze a company’s fundamentals because they are all accounted for in the stock’s price. Technicians like Merit believe that all needed information about a security is found in its price.

Fundamental analysis takes a relatively long-term approach to analyzing the market compared to technical analysis. We take an intermediate timeframe of weeks or months – by no means a day trader while a fundamental high yield manager may hold the bonds for a very long time, even to maturity.

Additionally, since we predominately trade high yield bond funds for our clients there is already fundamental analysis being done at the fund level by the fund’s portfolio manager. While the mutual funds do have the benefit of professional management and they do an excellent job selecting individual bond issues (bonds) for the funds, many don’t attempt to gauge when it is a good time to be invested in the high yield bond market. As such, you can select the best high yield bonds only to watch your account value decline with all the other high yield bonds. This is where we add value to our clients in determining the “When should I be invested in the high yield market”. Over the past decade we have only been invest in high yield bonds about 2/3 of the time.
Thus, Merit accounts benefit from fundamental analysis at the fund level and achieve enhanced returns, lower drawdowns and lower risk because of Merit’s technical overlay.

When you first founded the firm, did you have any idea that bonds were going to do so well?

The firm was founded back in 1987 by Paul Cunningham. After working with Paul for 9 years he decided to retire last quarter. We are appreciative of the knowledge that Paul passed on to us about both the model and the high yield market. From conversations with Paul, it’s impossible for him to have known that 25 years later, the model would still be outperforming the high yield market.

Paul and I actually met back in the late 80’s when Paul was hosting an investment seminar about high yield bonds. In 2001, at the age of 73, Paul was looking for a succession plan for Merit. After talking about things for 2 years I became a Merit Vice-President with the idea that I would one day own the company. After a few extensions, Paul finally decided to retire and we wish him well in his golden years.

At this time I have spent about 20 years on a bond trading desk and as a portfolio manager in a bank trust department and what intrigued me was Merit’s absolute returns and lack of investor drawdowns over a very long track record. The returns were low double digits and there wasn’t a negative year in the track record.

How were you able to achieve an investment growth rate that is 3 times greater than the stock market over the past 10 years?

There are a few reasons. First, we believe markets can be timed/tactically invested (when I was a large trust department portfolio manager, corporately we didn’t think markets could be tactically allocated) and as such our model has been on the right side of both up and down markets for high yield bonds. With our trend following system we enter the high yield market with a long position when asset prices are rising. Most important to many of our clients, our model has issued a sell signal before securities prices have declined too much and we have been able to watch the high yield prices fall from the safety of money market funds.

Another factor is that the high yield market is one where there are trending securities prices. These smooth price trends produces good entry and exit points for active portfolio management. We believe that the high yield market is one of the best trending markets available to investors.

Why have most investors not considered the benefits of investing in high yield bonds?

High yields are a sub-asset class for fixed-income and are below the radar screen for many investors. Also, many investors focus on their equity portfolios and pay little to no attention to the opportunities that fix income provide. There are so many asset managers who want to trade just emerging markets or commodities.

As an overlooked asset class, we believe high yield, fixed-income securities offer great opportunities.

Tell us about Merit’s High Yield Bond Strategy.

Did you ever hear the story of the “Tortes and the Hair” as a child? Merit’s high yield strategy is a version of that famous children’s story.

The service we provide is a technical trend following system for the management of high yield bond funds.

We operate a trend following strategy. That means we are not going to attempt to guess market tops or bottoms, we won’t attempt to “catch a falling knife” or sell a position because the market looks or feels overpriced. Thus, we buy securities after prices have reached their low point and have begun increasing. Sells occur in a similar manner and are after a security’s price reaches a high price and begins to lose money.

We don’t get distracted about news headlines or market events. As such we are not a fundamental asset manager as we don’t determined our allocations based on GDP or other economic indicators or the financial operations of any company. We can appreciate all the hard work of the analysts community, but these indicators don’t influence our buy/sell decisions.

There are other managers out there who do things differently than we do them. They may offer a trend predicting strategy where they project market tops and bottoms. As such their results well be different than Merit investor returns.

How many years have you used this strategy and what changes have you made to it since its inception?

For 25 years our high yield model has been navigating the high yield market. There has only been one adjustment in that time period.

Would you describe yourself as a market bond timer?

As a very smart man once told me “An honest confession is good for the sole”. Yes, we are high yield bond market timers. But, we aren’t day or momentum traders. We take positions of intermediate duration with holding periods normally greater than 30 days. We prefer to think of ourselves as “Quantitative Based High Yield Portfolio Managers”.

What investment instruments do you use?

The preferred instruments to trade for our clients are open-ended mutual funds. We have attempted to trade other instruments, but we are able to achieve lower draw downs and higher investment returns with the open-ended funds as compared to both the closed-ended funds and the exchange traded funds (ETF’s). Typically, a client’s portfolio will consist of two or three different high yield mutual funds for each buy. Funds are selected based on many considerations, including the market cycle, wash sale rule and other opportunities and constraints that may exist.

Do you ever take the short side of the market?

The answer is not at this time. First, there are limited inverse high yield fixed income products available. Currently, the available products for our model have good inverse correlation, but the scaling is off. For example, during March of 2008 we knew an advisor who was long high yield bond funds and long inverse bonds funds in equal dollar amounts. You would think this is adequately hedged; however, the long funds lost over three times what was made on the short side of the market. Until there are improvements in the products available for investment we will trade on a long only basis – but we are constantly looking for ways to profit from declining high yield securities prices.

What are the most important factors to consider when accessing the direction of the bond market?

Our efforts are to identify a trend for high yield bond prices. As such we look at various high yield market indicators to help us determine if high yield bond prices are improving, declining or are range bound –
( a situation where prices move up and down in a narrow range without material price improvements or declines).

Why do you concentrate mostly on the high-yield-Intermediate term bond markets versus other sectors of the bond market?

We believe there are opportunities to generate profits in other parts of the bonds market. As such we have worked on other models to trade U. S. Treasury and Municipal bonds, but we find that we have better absolute and risk adjusted returns in the high yield sector.

Is all of your investment research generated internally or do you also use other research sources?

We have an investment committee that conducts all our research. With that said we do review industry available data and market comments. As I mentioned we operate a quantitative trend following model that was developed by our founder, Paul Cunningham. Our clients hire us to operate our mechanical system and other than data providers, there isn’t much need for outside vendors or analyst to operate our system.

How did all your calendar returns remained positive even through bear markets like 2008?

We have patience because we are confident in our time tested system, we trade a suitable asset class and we don’t have management constraints forcing us to buy high yields when we believe that market will decline. Our outperformance to our benchmark (Alpha) has occurred because we were NOT invested when the prices declined for high yield securities. Unlike most money managers we don’t have to be invested all the time – our clients traditionally spend 1/3 of the time in money market funds. Many tactical portfolio managers feel the need to trade every day, not us. In most years we make only 10 trades or less – not active by any measure.

Also, we don’t have a mandate, like many managers, to be long or short 100% of the time. As a former portfolio manager in the trust department, we were long the market and if the market declined, so did the value of our clients’ accounts. The rising and falling tide of the market had more of an effect on our clients’ accounts than our investment ideas and hard work – often it was very frustrating.

The high yield asset class is one of the best trending sectors. As such a trend following system like Merit’s works very well for our clients.

What differentiates Merit as an asset/money manager is we are not always invested. We take a long position in the high yield market when our system quantifies that the conditions are favorable to do so. When market changes occur, and they always happen, our model generates a sell signal and we move our clients’ the safety of money market accounts to weather the storm.

What do you attribute your 48% calendar return in 2009?

For calendar year 2009 we enjoyed great returns with our high yield model – over 40% as you mention. Few market sectors or asset classes were as hard hit during the 2008 credit crisis as high yield bonds, as they lost 30% of their market value during the crisis. At one point there was a 1900 basis point (19.00%) spread between Treasury securities and the JP Morgan high Yield Index, which shows how risk adverse the market had become at the time. With all the panic in the market, we had a great back drop for solid investment returns. December of 2008 was an extreme that shows that in the high yield market there are times when extreme lows occur, creating future profit opportunities for investors and Merit’s clients.

Oh what a difference a year makes as 2009 was a great year to own high yield bonds because there was a perfect storm for price appreciation. The factors that allowed 2009 to be such a banner year for our model were as follows:

1. The credit crisis of 2008 produced very wide credit spreads that returned to a more normal level in 2009 (credit spread have historically affected high yield bond prices more than interest rate movements). As the credit spreads over treasury debt narrowed this caused an appreciation in high yield bonds. The real story was the narrowing of an all-time high credit spreads to a more normalized level.
2. Interest rates for U. S. Treasury securities declined causing an increase in prices for fixed income securities.
3 Investors needing more income transitioned assets from lower yielding assets to those with more income.

What bond programs do you offer and how do you compare them?

Our bread and butter program is what we have offered to clients for the past 25 years – the high yield bond service. We have another sister product for a select group of Multi-Sector bond fund. The reason I say select is our model functions best if assets are highly correlated to high yield bonds. For a mutual fund to be placed in a style (investment grade, emerging market, etc…) it must invest 80 or more of its assets in the named asset class. Since multi-sector funds can invest in almost any type of fixed-income instrument there can be wide dispersion in what they own and how their shares perform. As such, we have identified several multi-sector bond funds that have a high percentage of their assets in high yields while also having assets that are highly correlated to high yield securities. These opportunities work very well with our model.

We would love to have an equity model to offer investors, but we haven’t found a model that works well for long periods of time for the equity markets.

How do investment advisers use Merit’s services to help their clients?

We do more business with other advisors than we do with retail clients. Other investment advisors have a choice in how they work with Merit Advisors, Inc. and they have two choices. First, we can provide the advisor our buy/sell signs for a fee that is based on the fee paid to the advisor by their client. The advisor retains the client and has all trading responsibilities. Secondly, we have advisors that are solicitors for Merit where Merit has all trading responsibilities. We have advisors doing both programs currently.

Do you have a way to profit if interest rates were to begin to soar?

For years this has been our most common question. When interest rates rise, it causes a decline in fixed income prices. As such rising interest rates make it challenging to profit in a rising rate environment. During the last 25 years we have traded some markets characterized by rising interest rates and have made profits for our clients. We are able to generate the profits by making long trades that are counter to the longer term interest rate outlook.

This is an unusual thought, but it is the reality – high yield bonds are more affected by the risk premium (default premium) than they are by interest rates changes. High yield bonds trade at a premium to risk-free assets such as the U. S. Treasury bond. During normal times, there is a 300 to 600 basis point premium paid to investors over that over a U. S. Treasury Bond of comparable maturity – meaning if a treasury is earning investors 1% the high yield bond will earn investors somewhere between 4% to 7%. However, in times of economic distress the credit spread will widen (increase) to ridiculous levels causing high yield bond prices to fall. Thus, in times of increasing or flat interest rates there can be great opportunities to trade high yield bond funds.

Since we have a 25 year track record we have examples of how our model/management performs in most market conditions. As mentioned earlier the worst year for high yield bonds was 2008 and Merit client had their ONLY negative year in our 25 year history – our average account lost 1.36% and the Lipper High Yield Index lost 28.84% for the same time period.

Merit normally underperforms the benchmark in a strong bull market for high yield bonds but far out performs in a bear market. In a non-trending market we can be above or below the benchmark. Through the end of 2011 our 24.5 year result was as follows versus the benchmarks:

Average Annual Compounded
Rates of Return for 24.5 Years

S&P 500
Buy-Hold

Lipper HY
Buy-Hole

Merit’s HY
Results

8.43%

7.30%

11.91%

We are very pleased with the ability of our system to produce superior results in all market conditions.

Who are the other principals in your firm and what are their backgrounds?

Donald L. Dillingham, CFA, CPA

Don received a BBA in Accounting from the University of Oklahoma and his MBA from Oklahoma City University. Don’s 25 year investment career included the following:

1. Led a team selected to help manage a portion of the Capital Purchase Program (CPP) for U. S. Treasury Department’s Troubled Asset Recovery Program’s (TARP).
2. Served as senior portfolio manager for two mutual funds managed by Merit Advisors.
3. Serves on the Board of Directors for two public companies.
4. Manages portfolios for a private equity portfolio.
5. Is a fixed-income trader.
6. Currently, serves as Merit’s President and
member of the Investment Committee.

Matthew Spangler

Matt graduated in 1999 with a BBA in Management. He entered the financial services industry in 1999 and for more than 10 years was associated with one of the largest financial/insurance companies in the U.S. In that position, Matt assisted clients in developing and implementing comprehensive financial plans. He joined Merit Advisors in February of 2010. Matt is currently Merit’s Vice President and is a member of Merit’s Investment Committee.

If I hired you can I still use my existing broker?

Currently there are several custodian/brokers with which we have working relationships. Otherwise we can often use an existing brokerage relationship.